Tuesday, October 21, 2008

"Turmoil May Make Americans Savers, Worsening `Nasty' Recession"......... Keynes Stops By. And What's up with TIPS Pricing?

From Bloomberg:

The U.S. may be on its way to becoming a nation of savers, whether Americans like it or not.

With home and stock prices declining and credit hard to come by, consumers who have fallen out of the savings habit are being forced to curb borrowing and rein in spending.

That is bad news for companies catering to them, which will have to retrench as well. Detroit automakers may need to slash costs and merge as Americans hold onto their cars longer. Shopping malls might be forced to shut as retail traffic trails off. Hotels may have to shelve expansion plans as vacationers become stingier with their dollars.

The big concern is that households, spooked by the turmoil in financial markets, will cut back rapidly and sharply, plunging companies into bankruptcy and deepening a recession that many economists say has already begun.

``If we did have a quick cut in spending, it could turn a pretty nasty recession into possibly the worst downturn we've seen in the postwar period,'' says Michael Feroli, a former Federal Reserve official now at JPMorgan Chase & Co. in New York. Even without a collapse of consumer spending, Feroli expects the economy to contract by 2 percent in both this quarter and the next....MORE

Boston University's Zvi Bodie's (then new) book was the take-off for William Bernstein's related commentary five years ago:

Zvi Bodie and the Keynes’ Paradox of Thrift

Most finance writers eventually violate the famous paradox of thrift described by Lord Keynes in the concluding chapter of The General Theory of Employment, Interest, and Money. To wit, many virtuous activities, while good for the individual, are bad for society, prime among which is saving—good for the security of the individual, but bad for the overall economy.

I plead as guilty as anyone. While extolling the virtues of indexing, value loading, and rebalancing, I freely admit that if everyone indulged, all these techniques would instantly stop working. (This is one of the arguments, in fact, against value investing, since it violates Rekenthaler’s Rule: if the bozos know about it, it doesn’t work any more. I tend to disagree, since this would have predicted a narrowing of the valuation gap between value and growth stocks during the 1990s publicity surrounding the value effect, and assuredly that did not occur, as growth stocks soared versus value stocks. But that’s another article.)

Academician, raconteur, and all-around good guy Zvi Bodie crosses this line in style with a noteworthy new publication, Worry Free Investing, assisted by veteran journalist Mike Clowes. The book combines Bodie’s nonpareil grasp of the financial markets with Clowes’ prose skill, providing solid advice to anyone seeking guidance on retirement saving. Stocks, he points out, are riskier than they seem, with expected returns far lower than the spectacular realized returns of the past seven decades. Investors also need to be cognizant of the covariance of the risks of their investment capital and their human capital. (That is, stockbrokers should own less equity than other investors, since their jobs already provide them with plenty of exposure to market risk.)

The major focus of the volume is Treasury Inflation Protected Securities (TIPS), which insulate investors against the hazards of inflation. So far, so good. TIPS are a wonderful asset class, with reasonable expected real returns and near total safety. In fact, when The Intelligent Asset Allocator was published in 2000, TIPS were yielding 4%.>>>MORE

Finally, The Economist had an article on TIPS that I haven't thought through yet, but is worth noting: Money in the street

Banking on inflation

WHEN markets move as rapidly as they have in recent weeks, anomalies appear, but spotting them is difficult. Sometimes £20 notes may actually be lying on the pavement, just waiting to be picked up.

TIPS, or Treasury Inflation-Protected Securities, are generally regarded as among the safest investments on the planet. They are backed by the security of the American government, the world’s largest economy. So, of course, are conventional Treasury bonds, but investors can lose a lot of money in Treasury bonds when inflation rises sharply, as it did in the 1970s. The investor who buys TIPS sees the redemption value (and the regular interest payments) rise in line with the consumer-price index.

As a result of this security, TIPS have traditionally offered a pretty low yield. But recently that yield has been rising; the 20-year issue was this week offering 3%. As a contrast, the index-linked gilt (a similar security issued by the British government) with a 2035 maturity was offering a yield of just 1.5%. Three percent is better than the yield on offer from most money-market funds, and it will rise with inflation.

Why the shift? One reason may be that inflation is expected to fall. In September, the annual rate was 4.9% but prices were unchanged month-on-month and the effect of falling oil prices (and the slowing economy) will pretty soon bring down the headline rate. Inflation protection is not as attractive as it was even six months ago, when commodity prices were surging.

Nevertheless, lower inflation seems fully reflected in prices, to say the least. One measure of value is the break-even inflation rate, which is the rate of annual price rises above which the investor makes more from TIPS than from conventional Treasury bonds. Mark Capleton, a strategist at Royal Bank of Scotland, says the break-even inflation rate is zero over the next five years and just 1% over the next ten. It would be a remarkable period of history for such a low rate to be achieved. Indeed, the temptation for governments round the world in the face of the credit crisis will be to inflate the problem away....MORE